Ideas from the 8th Italy Value Investing Seminar—Part 2

I travelled to the 8th Italy Value Investing Seminar on 12th and 13th of July 2011. Here are some of the ideas I found most interesting.

As the world fretted about the escalating Italian debt crisis, I was in the one place in the world that didn’t seem much to care—Italy. Life here still revolves around siesta, laughs and late-night dining. Worrying? Isn’t that for Germans?

To alleviate the crazed isolationism that can develop working at home, I travelled to the 8th Italy Value Investing Seminar in beautiful Trani, Puglia on 12th and 13th of July. The seminar included presentations by 20 practicing value investors from across Europe and the US.

Over the next few blog posts, I’ll briefly cover some of the better ideas presented at the seminar. Please note I have done no research on any of these ideas, and they’re really only for those who care to do further research themselves.

Lloyd’s investment approach focuses on restructuring/turnaround opportunities. He prefers companies with operational problems rather than financial ones, though, advising investors to avoid turnarounds that have too much debt. Management of such operations are less likely to successfully juggle a complex operational turnaround because they’re too focused on the debt situation.

His presentation started with the claim that ‘all the world’s a turnaround’ today. The good news is that it will turn around successfully eventually. The bad news is that we haven’t even started the turnaround yet – all the difficult decisions still lay ahead. Once that tipping point is reached and the world faces its problems squarely, there’ll be 1-3 years of economic pain, followed by several years of economic gain.

His stock suggestion was Cadence Design Systems (for subscribers to US value investing newsletter Value Investor Insights, see 27 May 2011 edition). Cadence is a leading supplier of electronic design automation software, which helps other companies in the design and manufacture of computer chips and printed circuit boards.

The market capitalisation is about US$3bn, the company has net cash, and its free cash flow per share substantially exceeds EPS. Current multiple is about 11 (based on cash flow I believe), and earnings have been growing at 30% per year.

The analyst called the stock a ‘picks and shovels’ way to play the growth in mobile technology products. The company is already several years into its turnaround, and ‘the heavy lifting is already done’. The analyst nonetheless believes ‘it’s a double from here’. He also called the management ‘outstanding’ and noted that management has been buying stock on the market in recent months.

Tom Russo (Gardner, Russo & Gardner)

Quite famous in the value investing community, Tom Russo runs a portfolio of stocks focused predominately on the highest quality food, tobacco and alcohol companies. The portfolio is concentrated and stock turnover very low.

Tom didn’t present a current investment idea, but offered several valuable concepts. He said that companies with the ability to reinvest profits at a high rate of return tend to be massively undervalued by the investment community. Nestle and Kraft both trade around 14 times earnings, yet Kraft has few internal growth options while Nestle has huge opportunities. Guess who paid a fortune to buy Cadbury? Kraft of course.

Perhaps even more important is that companies display a capacity to suffer. Deciding to invest for the future to the burden of current reported profits is incredibly important.

Nestle proved its capacity to suffer, pouring capital into Russia after the 1998 ruble crisis when others were fleeing. It spent many years and many millions developing the Nespresso concept that now generates huge profit for the company. It has also been a persistent early investor in China and India, with more pain to come no doubt.

Pernod Ricard displayed a similar capacity to suffer in China. Competitor Diageo left the market in early 2000s because of a downturn and operating difficulties. Pernod Ricard experienced much pain, but now dominates the rapidly growing market for premium spirits in China.

The capacity to suffer has also been displayed by international brewer SABMiller, which kept investing in China when others were leaving (including Foster’s). It’s also investing substantial amounts in India and sub-Saharan Africa. Just a few days before the conference, I read about how SABMiller built a new brewery in South Sudan in the years between the 2005 peace deal and the achievement of independence earlier this month. It’s likely to dominate the beer market in South Sudan for having taken this early risk.

Don Fitzgerald and Sebastian Lemonnier (Tocqueville Finance)

Don discussed Gategroup, a Swiss-listed market-leader in airline catering and related services, managing a complex operation servicing 10,000 flights per day. It’s a tough business but one presumably with substantial economies of scale, which allows Gategroup to turn 5% EBIT margins into a 15% return on invested capital. Because of longer-term contracts, the company has fairly predictable results coming in over the next 3 to 7 years. Major risks include contract loss and client failure (top 5 customers circa 45% of sales). The company is well funded with a substantial pile of net cash, and trades on an 2011 estimated free cash flow yield of 14% and 5.1 times enterprise value/EBITDA ratio.

Sebastian covered Ekornes, a Norwegian manufacturer of very-high end sofas and chairs. The company is focused on comfort and ergonomic design, for which it’s built a substantial reputation and customer loyalty. All production is in high-cost Norway, but costs are kept down by automated production. It has fairly loyal retailers because Ekornes products tend to be the most profitable per square metre for these retailers. Its distribution network is growing. The company has historically achieved 18-19% EBIT margins on which it's generated ROCE approaching 30%. Sales have been growing at around 5% per year. The stock is trading on an 2011 estimated free cash flow yield of 9% and a dividend yield of 6.6%.

Martin Wirth (FPM Frankfurt Performance Management AG)

Martin made two suggestions, one of which – Commerzbank – is beyond the realm of competence for this author and thus won't be discussed here. The other suggestion was Takkt AG, a German-based global mail-order supplier of office furniture and business equipment. Australian investors can think of it similar to Corporate Express, business-to-business based but focused on lumpier office items rather than stationery. It similarly relies on intelligent acquisitions as a backbone of its growth. The company is cyclical but also growing structurally. The business has high barriers to entry, and Takkt achieves EBIT margins in excess of 10% and return on tangible assets of 40-50%. It trades on a 2011 forecast EV/EBIT of 8 and a forecast PER of 11.

Christoph Hilfiker (LLB Asset Management, Liechtenstein)

Christoph is focused on investing in Japan, on the conviction that ignoring Japan could be one of the biggest investment mistakes over the next 20 years. He showed some general slides, debunking the myth that high GDP growth countries offer the highest stockmarket returns over the very long term (100 years).

The analyst believes that Japan is currently a playground for value investors, with 10% average free cash flow yields (versus around 6% in the US and Europe). He also tried to counter the belief that Japanese companies aren’t shareholder friendly—the increasing influence of foreign investors (up from 10% of the market in the early 1990s to 30% today) has encouraged a big lift in important indicators of shareholder-friendliness, such as dividends and share buybacks.

Next, Christoph presented three value ideas. The first was Nippon Paper Group, a shrinking business that he assesses based on liquidation value. The free cash flow yield is more than 20%, price to book value 0.4.

The second stock was Sony, which is going through significant upheaval because of the Japanese earthquake and also a data leak. Costs of the two are expected to be JPY180bn, but market capitalisation has fallen JPY800bn. The stock trades on a free cash flow yield in excess of 20%, price to book ratio of 0.6 and there has been no capital dilution since 2005.

Lastly the analyst covered Sumitomo, a general trader with strengths in steel pipes and non-ferrous metals (gold, copper). It has a large property holding and rental stream, very strong financials and ‘steady’ management. The business has high barriers to entry. The stock trades at a 30%+ discount to the analyst’s estimate of reproduction costs, and a 70%+ discount to his discounted cash flow valuation.

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